But That’s What It Cost!
But That’s What It Cost!
When And Why The Cost Approach Is (And Isn’t) Appropriate For Commercial Real Estate
Of the three ways to value a piece of income producing real estate – Income Approach, Cost Approach, and Sales Approach – it would seem that the Cost Approach would be the least controversial.
IT COSTS WHAT IT COSTS TO CONSTRUCT A BUILDING, THE MONEY HAS BEEN SPENT. WHO CAN ARGUE WITH THAT?
The cost approach is a real estate valuation method that assumes: the value of a property = the cost of land + the cost to construct an improvement – depreciation. BUT IN THIS CASE 3+2-1 DOES NOT EQUAL 4 and market forces will have a huge impact on the variables, especially if more than a few years have elapsed since construction of the building.
- Land Sales: The cost approach assumes good data related to recent sales of similarly zoned vacant land is available. This can quickly become an issue because good, comparable vacant land sale data is simply not available in many markets.
- Labor & Material: The price of labor and materials change rapidly, as do design requirements and market preferences. For example, is the type of material used during construction still being used today? Maybe a new roofing material or HVAC system came to market, and your property has an older, less desirable model. Changes occur so quickly and frequently in regard to innovation related to construction materials and design that a few years can be a lifetime! This adds many variables to cost such as age, condition and locational differences. Additional adjustments can and should be made if the property has not yet been stabilized such as leasing commissions, marketing costs, rent concessions and tenant finish costs.
- Wear & Tear: Depreciation assumptions can be considered at day 366 after completion. Even when a building is constructed using the most modern material and current best practices, wear and tear is inevitable without constant maintenance and capital improvements. But that is a topic for another post.
- Becoming Obsolete: Finally, consider functional and external (economic) obsolescence. Is there a design feature of the building that is no longer useful in today’s market? Can it not be easily changed, like a ceiling height that is lower than current distributors demand? Is “green design” standard in the market now, but wasn’t at time of construction? Have the neighborhood uses (zoning) or character (redevelopment) made your building less desirable or less marketable than it was before? IF YOU ANSWERED “YES” TO ANY OF THESE QUESTIONS, then you are entering the world of functional or economic/external obsolescence. There are several categories buildings can fall into, and different adjustments to be made for each type of obsolescence that may exist. Is it curable or incurable? Does it require an upgrade? Were there improvements made to the building that went above and beyond anything else in the market and are only applicable to the tenant for which it was originally constructed and therefore do not add to the value? Did you expand or modify a building in a way that generated significant demolition requirements within the original footprint?
SEE HOW QUICKLY COST GETS AWAY FROM VALUE GIVEN ANY TIME LAPSE SINCE COMPLETED CONSTRUCTION?
When all of the above variables are considered, the cost approach is as easily influenced by individual opinion as the sales and income approaches to value. When dealing with commercial real estate, the cost approach is most acceptably applied in situations where there is a lack of market data to value the property by income or sales, or during/immediately following construction. In almost any other situation, the income and/or sales approaches to value are the preferred valuation methodology by appraisers and local assessment authorities.